Management of foreign exchange reserves

Secondly, PoBC has been using the sterilization tool to alleviate the inflationary pressure arising from an increase in monetary supply. However due to inefficiency and imperfection of the Chinese financial markets, such a tool does not always achieve its aimed policy objectives. The recent asset bubble in housing and stock markets in China has been argued to be related to excessive monetary supply. Thirdly, there has been observed an increased incidence of double settlement of exchange in China. It leads to increasing liquidity in the market and further inflationary pressure.

Low return, particularly against the background of the weakening US dollar Again there is no official data on performance of SAFE's investment. In Table 3 shows that the period average return in USD value was above 5% in nominal term. The exception is the year of 2008, where the nominal return was only 1.9%, largely due to the market downturn. If inflation is considered, the real return would be -1.9% for the year of 2008, and 2.1% for the whole observation period.

Given that liability associated with the excess FX reserves are domestic, it is worth knowing whether the return is satisfactory in Chinese currency. Unfortunately the result is discouraging. In other words the real value in terms of Chinese RMB is much less than that in USD value. The period-average return after consideration of both inflation and currency risk is only 0.4%, although the adjusted return in nominal terms is higher at the level of 2.7%. The worst period is 2008, in which year the real return was estimated to be as low as -11.1%.

However, we may view the year of 2008 as an exception or outlier. Therefore if we exclude this year, the results are improved. Nevertheless, SAFE's investment over the observation period in the U.S. features unsatisfactory return, and such performance has been subject to both investment risk and currency risk. Potential loss has been becoming more noticeable, therefore increasing attention/criticism within China in recent years. In addition to the Chinese leaders, people from other groups of society have also been questioning the performance of SAFE. It is particularly the case in recent years, since it was reported that several new investments of SAFE on risky assets abroad have incurred significant losses.

• Competition between SAFE and CIC. In September 2007 China established its major sovereign wealth fund (SWF), the Chinese Investment Corporation (CIC). The Chinese government injected an amount equivalent to USD 200bn to the CIC. The fund was originally from the FX reserves, but swapped with special bonds of RMB 1.55 tr. issued by the Ministry of Finance (MOF). Regardless of the highly debated question, i.e. whether CIC's investment is politically driven or purely commercially oriented, CIC does have strong pressure on returns, and aims to be a leading global asset manager. In this context, CIC has been aggressive since its inception in terms of both investment and international presence. For example, it conducted several major overseas investments, e.g. on Blackstone and Morgan Stanley in 2007. They have been emerging as the first official SWF in China, therefore actively representing China in the international community, notably in the International Working Group of SWFs.[14, 37]

All of these developments are in direct competition with SAFE because CIC may request the State Council for agreement to transfer more FX reserves from SAFE. Indeed in theory the Chinese government may assign the task of traditional FX management to SAFE, while that of investment of excess FX reserves to a SWF (i.e. CIC). Several studies show that the excess FX reserves in China could be as large as USD 600bn as of 2007 (Cheung 2008), and up to USD 1.5 tr. as of 2009. Recent creation of CIC looks likely to be consistent with this hypothesis, i.e. separate management of the growing Chinese FX reserves. Therefore if CIC could prove to the Chinese leaders that they are more capable of managing FX reserves than SAFE, it is likely that more assets would be transferred from SAFE to CIC, as indicated by Chairman Lou of CIC in a public event [12, 21].

In addition to the possibility of higher return by CIC, we believe that CIC has another major advantage when compared to SAFE, namely a more transparent organizational structure, or at least strong, public commitment to be as transparent as many other SWFs in the future. For example, CIC recently released its first annual report (2008), which although does not include much information, but is a good start in the right direction given its short history. However, as far as SAFE is concerned, opacity is the major hurdle limiting SAFE's capacity in competing with CIC, particularly on the issues of large overseas investments, if SAFE keeps its existing organizational structure unchanged.

Abroad • Large and rapidly rising assets and associated concerns. A high concentration of SAFE's portfolio in U.S. government bonds also raises concerns in the U.S., on the grounds that the Chinese government might be able to use the position of a large creditor as leverage against the national interests of the latter. However, this argument holds in theory, while in practice it is not achievable or at least not desirable for both the Chinese and U.S. governments. [12, 18]

SAFE investment has been becoming less conservative and in fact more aggressive than many other central banks in this context. This trend can be observed from the portfolio of China's investment in U.S. assets, i.e. an increasing amount of reserves have been invested in government agency bonds and equities.  It was reported that at the end of 2006 SAFE started its direct investment.

SAFE reportedly purchased shares in various UK financial firms, e.g. USD 345.4m of Barclays and USD 340.9m of Royal Bank of Scotland. Furthermore, SAFE has also quietly built up stakes in natural resources companies in 2008/09. SAFE bought shares of Royal Dutch Shell at an amount of USD 1.2bn, and Total at USD 2.8bn. In addition to equities, SAFE has been also reported to be open to investment opportunities in alternative assets, e.g. private equity. The trend of investment diversification might also be consistent with the reported new recruitment of former Wall Street talents in recent years. It seems that SAFE is starting to act like a SWF, rather than a conventionally viewed FX reserve manger.

• Lack of transparency. Perhaps what foreign observers are more concerned or worried about is the possibility ofpolitical decisions behind SAFE’s investment under the guise of seeking a diversified portfolio, e.g. engaged in obtaining sensitive technology by acquiring foreign firms, or achieving some geopolitical ends. We believe that this concern is legitimate. The main reason for this is that as a governmental agency, SAFE will continue serving the needs of national interest if needed and requested to do so. However, given the potential impact afterwards, it is plausible to believe that SAFE will avoid, or at least minimize involvement in these kinds of activities in the future, if at all possible[14,39].

This kind of concern is largely attributable to lack of transparency of SAFE. Regarding portfolio data, the only disclosed information by the authorities is total size, while portfolio composition is not published yet, nor is investment performance. Meanwhile, concerning the organizational structure of this institution, public information is also minimized. As a result, opacity of SAFE has aroused much attention, and also often led to suspicious views on its activities, particularly those related to foreign investment. It is believed that improving transparency of SAFE is one major issue the authorities need to tackle. Without this change, SAFE would not be able to invest in an optimal manner.

3.2. Recommendations

Fundamental issues

Accumulation of excessive FX reserves is difficult to avoid given the uncertainty on various factors, e.g. foreign trade, capital inflow. However, for the Chinese case there is a general consensus that China has been holding FX reserves in an unnecessary and excessive amount. Therefore, the first and fundamental approach in addressing this problem is to reduce the current level, which accounts for approximately 1/3 of the global FX reserves, or the speed at which it grows. In this regard, the Chinese government would need to adjust its economic growth model, from over-relying on export and investment to a more balanced approach, i.e. with a higher domestic consumption (OECD 2010). In this context, a well-functioning social security system in China would be able to play an important, positive role, since many Chinese people restrain their consumption, mainly because of the three contemporary “mountains”, i.e. weak health care system, expensive education, and rising cost of housing.

On the top, insufficient pension coverage and benefit is another important factor contributing to high savings rates in China (Salditt et. al. 2007; Hu and Davis 2009). Meanwhile, the rising gap between rich and poor in China should also be addressed, on the grounds that it has not only contributed to domestic social unrest in China, but also largely constrains the capability of the lower-income population to consume more[12, 24].

In addition to relatively high household savings, the corporate and government savings rate has also been high in China. As a result, it leads to even higher investment, which might be highlighted by the recent asset bubble observed in Chinese metropolitan cities. Therefore solutions need to be found to resolve this issue as well. It is hoped that if China’s economic growth could be based on a more balanced approach, more products would be able to be consumed domestically, therefore leading to a smaller current account balance, thus ultimately a lower level of FX reserves. On the other hand, re-balancing China's growth model would also potentially help in alleviating some global macro-economic issues, e.g. global imbalances, therefore benefiting the global economy.

Greater flexibility of exchange rate policy. Since July 2005, China has been implementing the managed exchange rate policy, i.e. the RMB is pegged to a basket of foreign currencies, notably the US dollar24. Research on China’s exchange rate policy is extensive, and many argue that the Chinese RMB is undervalued, and as a result it gives Chinese exporters an unfair advantage, and consequently a large trade surplus, and eventually an accumulation of FX reserves. Chinese policy makers have been aware of this issue, and have repeatedly emphasized their intention to gradually make the current exchange rate regime more flexible (i.e. implicitly appreciate RMB in the long run), but this process will be gradual and conditional on various factors (e.g. economic performance). One key reason explaining why the Chinese government

is so cautious about its exchange rate policy (i.e. RMB appreciation) is related to the potential negative impact on the export industry and employment. Indeed it is of crucial importance to the government, since it is widely believed that China needs to retain its economic growth at (at least) 8% per annum, otherwise it would lead to rising unemployment, social instability and ultimately, more importantly political instability.

This worry is understandable but the government might be over-concerned. It is recommended that the process of RMB appreciation could be faster, thus reducing the speed of rapid FX reserves accumulation in China. There are two reasons for it.

1) The Chinese labour market has demonstrated itself to be more flexible and resilient than what was commonly viewed, and even performed better than many OECD countries during the current economic crisis.

2) Export industry in China is on the lower end of the global product chain, which features extensive use of unskilled labour and is also often associated with environmental damage to the local areas.

Liberalisation of capital account. A large and rising capital account surplus is another contributing factor to the large FX reserves in China. Therefore, liberalization of capital account in China is relevant here. Capital flows from and to the country are strictly controlled by the Chinese government, whilst inflow is generally subject to less restrictions than outflow. Given the greater difficulty in restricting capital inflows (e.g. FDI) now, it might be advisable to alleviate controls on capital outflows (Truman 2007). This liberalization might be applied not only to SOEs, but also other entities, particularly those purely commercially oriented ones, e.g. private firms and individual investors.

This action if taken properly could help in addressing the current problems on different aspects[12, 27].

1) It reduces the level, or at least the speed of rapid accumulation of FX reserves.

2) It soaks up extra liquidity from the domestic economy, thus mitigating inflation pressure.

3) It facilitates domestic firms to invest in a diversified manner, and improve allocation of funds, for example by shifting away from risky real estate industry and the stock market.

4) Collectively, separate investment decisions by a wider group of the population and entities may not necessarily underperform that of one institution (i.e. SAFE) or selected and approved entities.

5) If foreign investment from China is conducted by a large amount of un-related, separate entities, e.g. SOEs, small firms and individuals, it would help reduce public attention abroad, and therefore to some extent play down concerns raised by foreign observers. The benefits of a more liberalized capital account for China.

However, some caveats warrant attention.

1) Liberalization of capital account or financial liberalization in general should not start when the institutions and macroeconomic conditions are weak and insufficient. International experiences show that the managed exchange rate regime with a liberalized capital account is prone to crisis.

2) Foreign markets are not free of risk, so Chinese domestic investors (firm or individual) should understand the importance of prudential investment, since they in general have less experience in international investment. If they are allowed to invest freely abroad, losses would be unavoidable, as highlighted by CIC’s investments in Blackstone and Morgan Stanley in 2007.

Further diversification. SAFE’s foreign investment needs to be diversified. It could be achieved by diversifying by type of currency, asset category, and geography. At the outset it is worth noting that given the size of Chinese holdings abroad, it may be more advisable to diversify the flow of FX reserves, rather than dramatically changing the stock, given the potential negative impact. As noted earlier, up to 60-70% of China’s FX reserves are invested in US dollar dominated assets. However, as of 2009, China’s export to the U.S. relative to the total Chinese export was 18.4%, while China’s import from the U.S. relative to the total Chinese import was 7.7%. It indicates the excessive holding of Chinese FX reserves in the U.S. dollar. Meanwhile, as analyzed above, currency risk has been one of the important factors affecting returns of SAFE investments in the U.S. Therefore, given the condition that RMB will appreciate against the US dollar gradually in the future, it is recommended that Chinese foreign investment be diversified into other currencies, e.g. Euro[12,27].

 A large proportion of China’s FX reserves are held in the form of government bonds and other similar fixed-income products. It reflects the legacy of SAFE as a traditional FX reserves manager. However, with rapid accumulation of FX reserves in recent years and the expectation that the trend continues in the foreseeable future, it might be worth considering more investment in riskier assets, e.g. equity and gold. The main reason is that if conducted prudently, riskier investment is likely to provide a higher return in the long run, which is relevant for SAFE, since the excess FX reserves do not have immediate liability. SAFE investment could also be diversified into different regions, including both developed and emerging economies. Traditionally China’s FX reserves have been invested in advanced countries, which reflects not only the high share of foreign trade with these countries, but also the relative safety of the assets due to a stable political situation and sound macro-economic conditions. However, with growing international trade with emerging markets and stabilization of country risk in these countries, geographical diversification might be beneficial to the overall performance of the SAFE portfolio in the long run. Also, more foreign investment by the Chinese to other countries, e.g. to the Eastern European countries, would potentially help their local economies and raise living standards, since some of these countries have been greatly in need of capital, but had difficulties to receive or secure funds from other sources in recent years.

Establishment of a separate investment company. In view of the problems associated with the current regime of FX reserves management and SAFE in particular, a separate investment company could be established to manage the excess FX reserves. There are several important benefits for this.

First, it would significantly improve its transparency, and build up confidence both in China and abroad. As a firm at arm’s length from SAFE and the People’s Bank of China, it would be much easier for CIC 2 to meet the requirements considered as international best practices, For example those specified in the SWF Santiago Principles - Generally Accepted Principles and Practices (GAPP).

Second, as a commercially oriented investment company, CIC 2 will have much less constraints in hiring high quality staff, thus conducting more professional investments. According to the current institutional structure of SAFE, all staff are either civil servants, or PSU employees which is particularly the case for the Department of Reserves Management . Therefore, even the salary structure of many of the PSU type SAFE employees is more flexible than that of civil servants, it is still subject to strict government regulations, and in general the remuneration package is much less competitive to that prevailing in the market.

Third, competition between SAFE and CIC has already taken place since the inception of CIC in 2007. Both parties recognize that if one party underperforms more than the other, it is likely that the former will be taken over by the latter, or at least has pressure to improve performance so as to assure the government that they are still capable of doing their job. Benign competition is argued to be one key reason why the Chinese government formed CIC in 2007. If this thinking is correct, therefore in view of the growing FX reserves and the bottleneck in managing the reserves better largely due to the current institutional constrains of

SAFE, it should not be difficult, and in fact reasonable for the central government to approve establishment of CIC 2 in China, but under control of SAFE or the People’s Bank of China, rather than the Ministry of Finance in the case of CIC.

SAFE should focus its main function on traditional FX reserves management. In this context, investment strategies typically are more conservative, while government bonds and other more liquid assets are still heavily held. The ideal AUM of the SAFE is the amount needed to meet its short-term external debt and import payment, while the excess FX reserves should be transferred to either CIC or CIC 2, according to their performance.

CIC could be delegated to invest in more risky assets in domestic and particularly global markets, as it is currently emerging. combination of both risky and conservative investments. The question of how much of the FX reserves should be injected to CIC 2 from SAFE at the inception is out of the scope of this paper, but the government could start with an amount equivalent to the CIC's initial injection, i.e. USD 200bn. For both CIC and CIC 2, they should be allowed to invest in a broad range of assets, as long as they can achieve higher risk-adjusted returns in the long run. The government should set up performance evaluation targets, which could however vary between them since they are basically two asset managers with different types of mandates. Nevertheless, it should be noted that it is difficult to avoid any overlapping areas between CIC and CIC 2 in terms of investments, but the focus of their portfolio should be differentiated beforehand so as to encourage and facilitate a benign and orderly competition between them, consequently in the best interest of the Chinese government and ultimately the Chinese citizens.

 

Conclusion

Foreign-exchange reserves in a strict sense are 'only' the foreign currency deposits and bonds held by central banks and monetary authorities. However, the term in popular usage commonly includes foreign exchange and gold, special drawing rights (SDRs) and International Monetary Fund (IMF) reserve positions. This broader figure is more readily available, but it is more accurately termed official international reserves or international reserves. These are assets of the central bank held in different reserve currencies, mostly the United States dollar, and to a lesser extent the euro, the pound sterling, and the Japanese yen, and used to back its liabilities, e.g., the local currency issued, and the various bank reserves deposited with the central bank, by the government or financial institutions.

The following are some of the main reasons for holding reserves: reserves are sometimes held as formal backing for the domestic currency, more common is the use of reserves as a tool of exchange rate or monetary policy and to provide funds for servicing foreign currency liabilities and debt obligations. 

The optimum size of the reserves is an important area that is often given insufficient attention, particularly in emerging countries where the background has traditionally been one of concern over having too few reserves rather than analysis of whether the authorities have too much.  Any debate over the optimum size of the reserves has two main elements.  The first is the correct identification of the uses of the reserves and therefore of the minimum required to meet the identified needs. The second element is a correct analysis of the cost of funding the reserves.  These two elements together provide a lower bound to the reserves (enough to meet the uses identified) and a pressure not to increase the reserves without limit above that.

The process of delegation and control should be completed by a regular review and reporting schedule.  This will enable senior management to retain the overall control of the reserves management process.  If the structure is designed properly, it will also identify which part of the overall return stems from which decision, thus enabling all levels to see directly the results of their own decisions.  This direct and highly visible connection between decisions taken and profits earned is both essential feedback in analysing performance, and also an excellent motivator for junior reserves management staff.

If, on the other hand, senior management retains direct control of investment decisions, junior staff will act merely as order-processors, with little incentive to add value to the reserves management operation.  As well as being likely to result in missed profit opportunities, this is demotivating for the junior staff involved and fails to develop the next generation of senior managers.

Given the great degree of delegation in reserves management, the importance of maintaining overall responsibility and control as the counterpart to this delegation has already been observed.  As well as a formal structure of decision-making and a formal monitoring system to ensure that limits are adhered to, this requires a comprehensive reporting system, through which senior management can observe the consequences of the investment decisions their portfolio managers have undertaken. There are internal and external reporting.

With rapid economic growth and continuing economic integration with the outside world, China’s foreign exchange (FX) reserves have been accumulating sizably in the past, particularly over the past 10 years. As of 2009 it stood at USD 2.4 tr., accounting for just under 1/3 of the global FX reserves. On the one hand, huge amounts of FX reserves demonstrate the enjoyable position of China in terms of foreign trade; on the other hand it leads to many problems, e.g. inflationary pressure, asset bubble.

Against this background the Chinese government has been concerned about how to better manage its FX reserves. In this paper after a careful case study on SAFE – a governmental agency in charge of administering and investing China’s FX reserves, the following policy recommendations are proposed from various angles and aim at suggesting solutions which could benefit both China and the outside world: First of all, the economic growth model in China needs to be changed, which has directly contributed to the rapid growth of FX. Therefore the government needs to stimulate its domestic consumption - through an improved social security system, and reduce over-reliance on investment and export. It would also be helpful in terms of reducing global imbalances.Second, a greater exchange rate flexibility might be allowed, which would enable reducing FX reserves, and more importantly help upgrade the Chinese export industry from the lowcost end of the global chain to the upper end featuring high quality and its own brand. Nevertheless, we admit that this process would be gradual and cautious.Third, given a continued, steady surplus in the capital account, the government might consider liberalizing its capital account. In view of the current situation, capital outflows could be liberalized further, so allowing not only SOEs, but private firms and individual investors to invest abroad. This would greatly diversify the risk concentrated on one institution, or this small number of selected institutions. Fourth, SAFE investment needs to be diversified further. It could be achieved by currency, type of asset and geography. Geographical diversification, for example, could potentially help those countries in need of capital to develop local economy and further raise peoples' living standards. However, in order to ensure such a transition as smooth as possible, the diversification could first start with the new flow of FX reserves, rather than the huge stock.